Mises Wire

How Central Banks Enable the Money-Creation Process

According to traditional economics textbooks, the current monetary system amplifies the initial monetary injections of money. The popular story goes as follows: if the central bank injects $1 billion into the economy and banks have to hold 10% in reserve against their deposits, this will cause the first bank to lend 90% of this $1 billion. The $900 million in turn will end up with the second bank, which will lend 90% of the $900 million. The $810 million will end up with a third bank, which in turn will lend out 90% of $810 million and so on.

Consequently the initial injection of $1 billion will become $10 billion (i.e., the money supply will expand by a multiple of 10). Note that in this example the central bank has actively initiated monetary pumping of $1 billion, which in turn banks have amplified to $10 billion.

However, does all this make much sense given that the central banks in the world today do not target money supply but rather set targets for the overnight interest rate like the federal funds rate in the US and the call rate in Japan. Additionally, in some economies like Australia banks are not even compelled to hold reserves against their deposits. Surely then the entire multiplier model in the economics textbooks must be suspect.

Indeed economists from the post-Keynesian school of economics (PK) have expressed doubt about the validity of the popular framework. In the present monetary framework, it is held, the job of the central bank is to ensure that the level of cash in the money market is in tune with the interest rate target.

For instance, if on a particular day the Government intake of cash exceeds outlays this leads to a deficiency of cash on the day. To prevent a scramble for cash in the money market and a subsequent increase in the overnight interest rate, the central bank must inject an appropriate amount of cash in order to keep the interest rate at the target. Note that the central bank here is performing a balancing act, or so it is held.

The PK school of thought maintains that as opposed to the popular money multiplier model central banks do not actively pursue monetary pumping to influence various economic data in the economy — as we have seen the central bank is just aiming at keeping the money market well balanced.

In fact, it is held, the textbook multiplier story is an impossible fiction. It is maintained that the pumping of cash reserves by the central bank in order to raise the pace of credit expansion will create excess reserves, which in turn will push the overnight interest rate to zero almost instantly.

On this logic, it would appear the central bank has nothing to do, at least directly, with an expansion in the money supply. (In fact, most central bankers would agree with this). The key source of money expansion is commercial banks that, via an expansion in lending, set in motion an expansion in the money supply. For PK economists’ commercial banks liabilities are seen as the primary money used by non-banks. The demand for loans plus the willingness of banks to lend determines the quantity of loans and thus of deposits created. As is usual with Keynesian logic, demand drives supply.

Thus, the supply of loans is never independent of demand — banks supply loans only because someone is willing to borrow bank money by issuing an IOU to a bank. To conclude then, according to PK the driving force of bank credit expansion and thus money supply expansion is an increase in the demand for loans and has nothing to do with the central bank.

Is the Money Multiplier a Myth or Reality?

Superficially, it does make sense to conclude that central bank policies are of a passive nature — the central bank just aims at keeping the money market in balance. A careful investigation of all this, however, reveals that the central bank’s so-called passivity is a misnomer. In reality central banks are very much active rather than passive.

In fact, without the central banks’ activity it would be impossible for commercial banks to expand lending and set the multiplier process (the creation of credit out of “thin air”) in motion.

Let us say that, for whatever reason, banks are experiencing an increase in the demand for loans. Also, let us assume that the supply of loanable funds is unchanged. According to PK banks will facilitate this increase. The demand deposit accounts of the new borrowers will now increase. Obviously, the new deposits are likely to be employed in various transactions.

After some time elapses banks will be required to clear their checks and this is where problems might occur. Some banks will find that to clear checks they are forced either to sell assets or are forced to borrow the money from other banks (remember that the pool of loanable funds stays unchanged).

Obviously, all this will put upward pressure on money market interest rates and in turn on the entire interest rate structure. Higher interest rates in turn are likely to force marginal borrowers out of the “game.” In addition, some banks will go belly-up because of not being able to honor their checks. Ultimately, this will put downward pressure on bank lending, which in turn will offset the initial expansion in credit.

To prevent the rise in the overnight interest rate above the interest rate target, the central bank will be forced to pump money. Once the central bank pumps money to maintain a given interest rate target it, in fact, gives the green light to the money multiplier process (the creation of credit out of “thin air”).

This accommodation cannot be labeled as passive — indeed it is very much active. Again, in order to protect the interest rate target the central bank is forced to pump money. So the conceptual outcome as depicted by the multiplier model remains intact here. The only difference is that banks initiate the lending process, which is then accommodated by the central bank.

It follows then that the so-called multiplier, or the expansion of credit out of “thin air,” cannot emerge without the support of the central bank.

If the multiplier process requires the support of the central bank then one can infer that in a free market without the central bank the likelihood of such a process emerging is not very high.

In a free market, if a particular bank tries to expand credit without backup from a genuine lender — i.e. it seeks to practice fractional reserve banking — it runs the risk of not being able to honor its checks, which raises the risk of bankruptcy.

Also, it must be realised that in a free market we should expect that the likelihood of a bank being “caught” if practicing fractional reserve banking is going to be high, as there are many competitive banks.

As the number of banks rises and the number of clients per bank declines the chances that clients will spend money on the goods of individuals that are banking with other banks will increase. This in turn raises the risk that a bank that practicing fractional reserve lending may not be able to honor its checks.

Conversely, as the number of competitive banks diminishes – that is as the number of clients per bank rises – the likelihood of being “caught” practicing fractional reserve banking diminishes. In the extreme case if there is only one bank it can practice fractional reserve banking without any fear of being caught, so to speak.

In a free market, then, without the central bank and with a reasonable number of commercial banks the fact that banks must clear their checks is likely to be a sufficient deterrent to the practice of fractional reserve banking.

Conclusion

We can thus conclude that it is irrelevant for the multiplier process whether the central bank targets the quantity of money or the interest rate. What matters here that the central bank is always ready to accommodate commercial banks’ expansion of credit out of thin air.

Without the central bank’s support the likelihood of a sustained multiplier process taking place is close to nil – hence the notion that the money multiplier is not applicable in a truly free market economy.